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Cyprus Shows Libor Still Broken

Benchmark rate ignored the crisis in Cyprus, with just four out of 18 banks showing increase in dollar borrowing costs.

Libor ignored the crisis in Cyprus that’s roiling financial markets, showing the global benchmark for $300 trillion of securities remains divorced from reality six months after regulators laid out a plan to fix it.

Just four of the 18 banks contributing to the London interbank offered rate in U.S. dollars increased submissions last week to show a rise in their estimated borrowing cost, as concern grew about bank runs and bailouts in Europe. UBS AG and BNP Paribas SA were among those reporting no change.

That week, the average cost to insure banks against default soared 12 percent, credit-default swaps show. The amount lenders paid to borrow cash from each other overnight, as measured by the overnight-indexed swap rate, rose more than 8 percent.

“Instead of providing the most accurate quote of their interbank borrowing costs, banks are playing safe and trying to provide the least-risky quote given current investigations,” said Rosa Abrantes-Metz, an economist with New York-based consulting firm Global Economics Group Inc.

Libor is calculated daily through a survey in London that asks banks how much it costs them to borrow cash from each other for various durations in different currencies. Banks including UBS and Royal Bank of Scotland Group Plc were given record fines over the past year for making false submissions to that survey.

With little interbank trading as banks tap other funding sources, lenders are forced to guess what their borrowing costs might be, leaving the rate open to inaccuracy and abuse.

Three-month dollar Libor rose 0.5 basis points, or 0.005 percentage point, to 0.285 percent between March 15 and March 22 as European policy makers clashed over a rescue for Cyprus and the island’s lawmakers resisted a plan to impose a tax on bank deposits. That increase shows banks estimate it costs less than 2 percent more to borrow than a week earlier.

During the same period, the average cost of a five-year contract to insure the senior debt of banks on the dollar Libor panel against default jumped by 11.9 percent as credit-default swap writers demanded a higher premium. Concern that a Cyprus deposit tax may prompt savers to pull funds from weaker banks elsewhere in the euro region helped send European stocks sliding.

Since March 22 the divergence between Libor and CDS has continued to grow. By March 27, three-month dollar Libor had dropped back 0.1 basis point to 0.284 percent, while the average cost of a CDS contract on the banks had risen a further 15.3 percent. It’s now 28 percent more expensive to insure the banks against default than it was on March 15, compared to the 1.4 percent increase to the Libor rate.

New Regulator

Britain is adopting a plan that aims to improve the way the London interbank offered rate is set. The Libor scandal erupted after London-based Barclays Plc was found to have made artificially low submissions during the financial crisis to avoid the perception that it was under stress.

“Libor may not be being manipulated currently, but it is not responding to market conditions the way it would be expected,” said Abrantes-Metz, who is also an associate professor at New York University’s Stern School of Business. “That compromises the reliability of Libor as a key benchmark, to the detriment of the market.”

The U.K. Financial Services Authority approved reforms this week that will see the Prudential Regulatory Authority, the new financial regulator, given responsibility for overseeing the rate-setting process, including corroborating submissions and monitoring suspicious conduct.

Libor rate-setters, who usually work in a bank’s treasury department, are no longer allowed to consider the views of derivatives traders who stand to benefit from where the rate is fixed each day. Traders found guilty of attempting to rig the rate can be jailed.

Martin Wheatley, head of the PRA, said on March 25 that the new rules would “restore faith” and “bring integrity back to Libor.” Chris Hamilton, a spokesman for the U.K. regulator, declined to comment.

The U.K. reforms “are designed to make sure Libor keeps functioning because it is the benchmark for so many contracts,” Abrantes-Metz said. “That is necessary, but users should start looking to alternatives.”

‘Fragile System’

Australia this week scrapped the panel that sets its benchmark interbank rate, becoming the first major developed economy to replace its rate-setting regime following the rigging scandal. The nation’s bank-bill swap rate will be compiled directly using prices from brokers and electronic markets instead of asking a panel of banks, according to the Australian Financial Markets Association.

Though the heightened regulatory scrutiny makes it harder for traders to manipulate Libor for their own gain, Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, has said the rate remains flawed given Libor still relies on estimates of a market with very few transactions.

“Propping up a fragile system in the interest of maintaining a sense of stability only creates more instability in the end,” Gensler said in a Feb. 28 speech in New York. ‘One can buy an artificial sense of calm for a while, but when that calm cracks, the resulting turmoil is invariably greater.”

Before the financial crisis, Libor and credit-default swaps tended to move in tandem. As perceptions of bank risk grew, CDS contracts became more expensive and lenders in money markets demanded higher interest rates for short-term financing. That relationship has broken down as Libor has become less responsive to market events, Abrantes-Metz said.

Last week, the divergence between CDS and Libor was particularly pronounced among the European lenders on the Libor panel. Of the 11 European banks that provide rates, eight left their submissions unchanged.

The U.S. dollar overnight-indexed swap rate, which gives an indicator of how much banks are paying to borrow cash from each other overnight and is based on actual trading, jumped to 0.1475 percent from 0.1362 over the same period, an 8 percent increase.

That meant the spread between Libor and the overnight indexed swap rate, a closely-followed barometer of stress in the market, fell to its lowest level in 19 months on March 22, the last day of a week where Cyprus’s crisis pushed Treasuries and gold higher on demand for the safest assets.

“This kind of divergence is going to keep happening,” said Andrew Verstein, a lecturer at Yale Law School in New Haven, Connecticut, and co-author of a paper on Libor rigging published in the Winter 2013 issue of the Yale Journal on Regulation. “You may see peculiar results, but as long as there is good governance and every effort to stop abuse, the market may decide that it wants to keep using Libor.”

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